Bitcoin's Deflation Problem

Bitcoin's Deflation Problem

Bitcoin Will Spiral Up and Down Forever

An electronic board flashes the numbers of the foreign exchange rate of the yen against $1 U.S. (top) at a foreign exchange brokerage in Tokyo on Feb. 6, 2013.

Photo by Kazuhiro Nogi/AFP/Getty Images

Tim Lee makes what is I think the strongest case for Bitcoin, arguing that it's not just a fad, it's a disruptive technology that can serve as a platform for improving on the world's generally clunky and unpleasant payment system. The reason the payment system rarely seems to improve is that there are massive barriers to entry into it, because the nature of the banking system is that it needs a lot of security and regulation. But with Bitcoin "[b]ecause transactions are authenticated cryptographically and cannot be reversed, there’s no need to restrict access to the network," so the network can experience robust competition and rapid innovation.

He says we should think of this like PCs in 1978. People dismissed them as a random curiosity, and it's true that the PCs of 1978 were not meant for the mass market. But enthusiasts and tinkerers were able to write more and better software, driving more and better demand for computers over the years.

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But where I think the analogy breaks down is with deflation. As computers started looking more and more useful and demand for computers grew, the world started building more computers. Bitcoins are deliberately designed to represent a finite supply. So if over time more and more people want to use Bitcoins to conduct transactions of various kinds, then the price of bitcoins is going to have to rise and rise. The problem is that if the price of a bitcoin is on a steady upward trajectory, then nobody's actually going to want to spend a Bitcoin on anything. And if everyone's hoarding their Bitcoins, then the network is actually useless. Then, since it turns out to be useless, you get a crash. The funny thing is that once the upward spiral comes to an end, then the technological virtues of the Bitcoin platform come to the fore again. If nobody wants to hoard Bitcoins, then Bitcoin-as-platform looks like an attractive alternative to elements of the payment system. But when Bitcoin starts looking attractive again, you should get a renewed hoarding cycle.

To put it in more jargony terms, expectations about the price level will be "unanchored" instead of rapidly mean-reverting, so it's going to be very difficult to ever have a platform that attracts a steady user base rather than a boom-and-bust cycle.